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June 20, 2014

ETFs ‘Next Evolution in 401(k)s,’ Schwab Says

ETFs are to mutual funds what broadband is to dial-up

“The time has come for ETFs in 401(k) plans,” says David Gray of Schwab Retirement Services.

“Today, mutual funds and 401(k) plans are almost synonymous,” Schwab’s David Gray said on the firm’s Every Third Friday media call. That wasn’t always the case, though. Gray, who is head of Schwab Retirement Plan Services' client experience team, said that in 1990, just 9% of 401(k) assets were in mutual funds. In only a decade, that number climbed to 49%.

Consequently, most major providers have built their business around mutual funds, Gray said, and exchange-traded funds as a core product in retirement plans challenges their business model.

Most major providers’ recordkeeping systems are built on end-of-the-day, mutual fund trading technology left over from the late 1980s and ‘90s, Gray said. “Frankly they have no desire to upset that business model.”

However, Gray said, “We think that’s going to change. We think the time has come for ETFs in 401(k) plans.”

In 2012, Schwab launched Index Advantage, a 401(k) platform that uses index mutual funds. The firm launched an ETF-only version in February, with 80 ETFs from 11 different providers along with Schwab’s proprietary ETFs.

The change from mutual funds to wider use of ETFs in 401(k) plans won’t be without challenges. Gray described the obstacles Schwab had to overcome to launch Index Advantage. “There were two main technical challenges,” he said. “One, we had to enable the intraday trading and valuation that ETFs require. And secondly, we had to handle the partial shares.”

Since ETFs are traded multiple times a day, technology built around mutual funds can’t keep up.

“We could have contorted ETFs to fit into this 1980s, 1990s mutual fund recordkeeping model. Had we done that we would have eroded the benefits of ETFs,” Gray said. Other ETF 401(k) solutions have done this, he said. “They unitized them. They do batch trading. They trade once a day. They take an exchange-traded fund and they treat it like a mutual fund to try to make it fit the 401(k) model.”

Gray said that Schwab “made a choice to invest in the future” by not following that path. “We built a patent-pending process that integrates the 401(k) recordkeeping system, our bank, trust and custody services, and our broker-dealer so that intraday trading and intraday valuation will be enabled within the 401(k) space.”

Bringing together those services at Schwab also helped address the second challenge: figuring out what to do with partial shares, Gray said.

“Mutual funds are built to handle dollar-based investments,” Gray said. For example, say a participant makes a contribution of $50 for a mutual fund share that costs $75. The participant can still buy a portion of that mutual fund. ETFs, however, only trade in whole shares.

“We had to accommodate it such that, that individual who made that $50 contribution for an exchange-traded fund of $75 still gets credit in their account for that partial share,” he said.

Gray addressed concerns that ETFs might tempt participants to day trade as a result of having access to the market throughout the day. “If you go back to the late ‘80s and early ‘90s when 401(k) plans transitioned from a periodic valuation — a quarterly valuation or an annual valuation — to what we know today, which is a mutual-fund-driven, daily valuation, that’s exactly what critics [then] said,” according to Gray. “They warned that making that change, giving participants access to the Internet so that they could place trades was going to be harmful to their retirement future. That didn’t happen, and it’s not going to happen here, either.”

Gray said that research shows participants use their 401(k) plan for a “buy-and-hold strategy.” Furthermore, he said, “when we look at investors who are using ETFs outside a 401(k) plan, they largely use ETFs as buy and hold. People who are active traders don’t do it in their retirement plan.”

Cerulli research shows that mutual funds make up the majority of 401(k) assets, with separate accounts and collective trusts lagging far behind around 13%, while ETFs make up less than 1% of assets in 401(k) plans. Gray listed several benefits to ETFs that he said make him “very confident this gap will close.”

They’re more transparent and also provide access to asset classes not available through a mutual fund like fixed income or broad-based commodities. “We think that will help individuals have better, more diversified portfolios.”

Finally, “they bring a sense of timeliness,” Gray said. “I think we’re in a generational shift in which individuals want access to more timely information; they want the freedom to act when they want to act. Exchange-traded funds enable that. It aligns with where we’re going generationally.”

Furthermore, “all the ingredients are in place to go to that next level,” Gray said. ETFs grew from $66 billion in 2000 to $1.7 trillion as of April, he said. Investors have put more money into ETFs than actively managed mutual funds in four of the past seven years, including the past three consecutive years, he said.

Sponsors are driving the shift too, as they become more aware of the impact expenses have on their participants. “They’re looking for that cost efficiency so that participants can be better prepared for retirement.”

He continued, “The missing piece has been around access.”

“I expect we’ll see the adoption rate of ETFs in 401(k)s quicken based on the growing demand for ETFs outside 401(k)s and the unique cost benefits. I think the question for the 401(k) industry is ‘How can we continue to ignore exchange-traded funds?’ Why shouldn’t 50 million participants enjoy the same benefits that individual investors get? This idea that the benefits of exchange-traded funds should not be available to 401(k) participants is like telling someone that they don’t need broadband because dial-up works just fine.”